Global financial markets have retained their ‘risk-on' mode going into the end of the year, cementing 2019 as a year of positive fixed income and equity returns.
Arguably, it may be some time until we witness another year in which gains are as impressive, given that we appear to have reached the limits of monetary easing in many jurisdictions and equity valuations are becoming stretched at 21x earnings on the S&P.
In many respects, 2019 has been a year in which macro fears have gradually melted away.
Worries of a US recession and excessive monetary tightening are now largely forgotten. Trade wars have been a lingering concern, but the passage of a first-phase US/China deal and the recent passage of the USMCA have suggested that trade headlines should be more benign going forward - at least until the US presidential election is out of the way in next year.
A ‘no deal' Brexit hasn't created disruption, and elsewhere in Europe, political trends have been favourable, in our view, enabling risk premia in the eurozone periphery to fall.
Geopolitical spats in Saudi/Iran have failed to escalate and, although political developments in countries like Argentina have been concerning to investors, there have been signs of more positive policy steps being taken elsewhere in the South American continent, such as social security reform in Brazil.
As these fears receded, so equity markets have managed to climb the proverbial ‘wall of worry'.
Investor sentiment through most of the year has been biased in a cautious direction, given a late-cycle narrative, but with earnings growing, central banks easing and governments moving to more expansive fiscal policies, the conditions came into place for a robust bull market, with indices rebounding following notable losses in the fourth quarter of last year.
Looking ahead, it may be tempting to believe that the current sentiment could last into the new year. There remains a sense that some market participants are underinvested, with cash to put to work.
If anything, it seems that instead of positioning for a positive start to the coming year, many have been more inclined to realise gains in the past few weeks and, if that is the case, we believe any pull-back in markets may well be bought into.
Reasons for growth optimism
In assessing the global economy, we continue to believe that the US can deliver growth above 2% in 2020. As we have written in recent weeks, we see no evidence of the economy being late cycle or at risk of recession any time soon, based on domestic fundamentals.
Typically, recessions occur in a cycle following a period of restrictive monetary policy, which is enacted in response to signs of an economy overheating and inflation pressures rising. However, in this cycle, inflation remains very muted and we expect this to continue to be the case in the quarter ahead.
For now, we discern an absence of greed in the economy, as evidenced by the very healthy state of consumer balance sheets. Wages show no real sign of accelerating, even with unemployment at historically low levels.
In this case, we are left wondering whether this cycle can continue to run and run and, as we enter a new decade, whether the economy can continue to defy those who want to foretell a story of doom and gloom.
We expect US monetary policy to remain on-hold during the course of the year - though we do believe that the next move in rates is more likely to be higher, rather than lower.
In this context, we feel that Treasuries can trade in a range between 1.6% and 2.3% in the months ahead, with a bias towards the top end of this range later next year.
For now, we don't see a compelling trading opportunity in US rates and feel that if there is a moment when the risk-on rally is punctured, triggering a flight to quality, then there may well be a better entry point to adopt a short duration stance than is currently the case.
The recent trade agreement may presage a somewhat better outlook in China over the next few months and this could be beneficial with respect to sentiment in Europe and emerging markets.
However, we would observe that debt levels in China continue to rise, notwithstanding efforts to deleverage the economy. This suggests to us that the need to rebalance is likely to continue to restrain Chinese growth over the medium term.
Against this backdrop, we feel that forward-looking growth indicators in the eurozone may lift in the next couple of months, but stronger growth may require additional stimulus to come from a more expansive fiscal policy.
In this respect, Germany is only inching in this direction given its stubborn desire to deliver a balanced budget. Consequently, it is hard to see much growth momentum building.
This being the case, interest rates in the eurozone may remain stuck at current levels for a long time and this could continue to act as an anchor to Bund yields.
The evolution of Brexit
In the UK, Brexit will be ratified at the end of January with focus turning towards the future trading relationship.
We are very sceptical that a comprehensive deal will get done by the end of next year, though we do believe that it is sensible politics to attach a deadline in order to increase pressure for progress to be made.
We would note that if an agreement has not been reached by next December, it will be easy for UK laws to be amended to lengthen the transition process and so we believe that the risk of a new cliff-edge ‘no deal' should be averted.
However, we will need to monitor this carefully and it will be interesting spending time with European policymakers in the coming few weeks to discern the attitude in Berlin and Brussels now that any hopes of ‘remain' have been extinguished.
Elsewhere in Europe
We continue to expect further material UK fiscal easing. Allied to a likely bounce in confidence following the comprehensive Tory win, we see the UK economic outlook improving in the next few months and believe that the Bank of England is unlikely to lower rates.
This being the case, we believe that Gilts remain rich versus other developed fixed income yields, with 10-year rates offering no yield pick-up versus cash.
By way of contrast, we retain a more constructive view in the Euro periphery - particularly in the first half of the year. We believe that an early Italian election is unlikely, with politics more of a risk in 2021.
In Greece, further rating upgrades are likely and the technical squeeze on spreads is set to continue. Hence, maintaining a long position in Italy and Greece versus Gilts offers both attractive yield carry and scope for further capital gains in the weeks ahead.
We also retain a relatively constructive view on corporate credit. Low interest rates, abundant liquidity and low recession risks should all be supportive for corporate bonds.
We are inclined to believe that lower-quality assets should outperform to a greater extent in the coming year, reversing some of the decompression trends seen in the past 12 months.
We remain relatively constructive on high yield and are also more optimistic on bank loans and CLO spreads after these have cheapened versus other parts of the credit market this year.
However, we continue to see most value in subordinated financials where AT1 spreads remain too wide versus tier two bonds, in our opinion. We are also constructive on corporate hybrids, which offer potentially attractive yields for assets which still have an investment-grade rating.
We believe this macro backdrop is also broadly supportive for emerging markets. That said, we note significant domestic economic challenges in countries like Turkey and South Africa, while domestic political challenges may continue to impact the performance of assets in Latin America in the months to come.
This could make for quite a heterogeneous return backdrop characterised by contributors and detractors.
Should China slow, the situation could become starker - and we would also note that any commitment by Beijing to buy more imports from the US could mean that demand could fall elsewhere. For example, increased US soya bean imports could see lower imports from countries like Brazil.
Carry to continue
In currencies, 2019 has been a year in which carry has been the winning theme with the top-performing currencies all being the high yielders, at a time when G7 FX volatility has remained very low and markets lack direction.
This backdrop may persist for the time being, though we can see more opportunities for relative value trades in areas like emerging markets, given divergent fundamentals and a clearer distinction between winners and losers.
Our new year's message
Vigilance will be needed as we enter the new year and, despite the benign backdrop, we would not be at all surprised were we to observe periods of calm in financial markets punctuated by periodic spikes in volatility.
Navigating these volatility spikes could be the key to a successful 2020.
Generally speaking, we are inclined to think that in range-trading markets, it will be important not to chase after price action and maintain an approach where we seek to sell periods of strength and buy into the dips.
Mark Dowding is CIO at BlueBay Asset Management